TAX NEWS - 
2010
U.S. Tax: Guidance revamps treatment of substitute dividends received by foreign lenders of U.S. stock
The notice can have an immediate adverse effect with respect to the gross-basis tax imposed on U.S. source substitute dividend payments - in particular, on payments made by one foreign person to another foreign person ("foreign-to-foreign payments").[5] In addition, effective 14 September 2010, the notice provides guidance under new §871(l)(6),[6] which authorizes administrative guidance to prevent excessive, or "cascading," gross-basis taxation ("over-withholding") [7] that can occur when dividends are paid on shares of U.S. stock that have been lent in a series by a succession of foreign persons.[8]
The guidance provided and contemplated by the notice is to be implemented in three stages:
Period 1: Immediate modification of Notice 97-66.[9] As of 20 May 2010, and through 13 September 2010, a withholding agent or foreign lender may not rely on Notice 97-66 to reduce the tax otherwise imposed by existing regulations if a transaction or series of transactions has a principal purpose of reducing or eliminating tax.
Period 2 (or "transition period") : 14 September 2010 through 31 December 2011.[10] As of 14 September 2010, Notice 97-66 is withdrawn. Taxpayers must apply the rules set forth in Notice 2010-46 for transitional relief (under the authority of §871(l)(6)) from over-withholding on substitute dividend payments made before 2012. To the extent §871(l) applies to any substitute dividend payment in 2010, the due date for withholding and depositing tax is extended until 31 January 2011, and the due date for filing any Form 1042-S is automatically extended until the earlier of (a) the date the form is provided to the recipient of the payment, or (b) 15 September 2011.
Period 3: Regulations to take effect on 1 January 2012. Notice 2010-46 describes future regulations to be issued under §871(l)(6). The regulations will provide valuable, comprehensive withholding tax relief to "Qualified Securities Lenders" ("QSLs") and an alternative form of over-withholding relief for payments made to non-QSLs. The notice's description of the future regulations also serves as the basis for the transitional relief that applies in period 2.
To derive the maximum benefit from the rules that apply after 13 September 2010, taxpayers must carefully evaluate all transactions that they enter into after 19 May 2010.
I. Matters requiring immediate attention
Notice 2010-46 has certain immediate consequences to persons who engage in stock loans or repos with foreign persons. Three key points stand out:
1. Transactions with a principal purpose of reducing gross-basis tax vs. Notice 97-66. If a U.K. owner of shares of the stock of a U.S. issuer lent the shares to a U.K. borrower over the dividend record date, and the U.K. borrower used the shares to cover a short sale to a U.S. person, many believed that the substitute dividend payment from the borrower to the lender was exempted by the "formulary method" in Notice 97-66 [11] from U.S. gross-basis tax - even though the payment was U.S. source income under final regulations.[12] Notice 2010-46 provides that such payments are not eligible for tax reduction or exemption under the Notice 97-66 formula if, after 19 May 2010, a foreign person lends shares to a foreign borrower after a dividend declaration, the borrower sells the shares to a related U.S. person before the ex-dividend date, and then enters into a total return equity swap with that related person in order to hedge its risk.
This is an example of what Notice 2010-46 treats as a transaction, or series of transactions, with respect to which the withholding agent or foreign lender knows, or has reason to know, that "there is a principal purpose of reducing or eliminating the amount of gross-basis tax that would have been due in the absence of such transaction or transactions." The new notice provides that any securities lending transaction or series after 19 May 2010 with such a purpose is ineligible for over-withholding relief under the 1997 notice. Notice 2010-46 does not expressly identify a pure stock borrowing by a foreign person to cover a short sale as having a principal purpose to reduce or eliminate tax, but neither does the notice expressly set forth any set of facts under which the parties to the substitute dividend payment can rely on the formulary method of Notice 97-66 to reduce or eliminate U.S. gross-basis tax after 19 May 2010.
Note – Notice 2010-46 states that no inference is intended that transactions entered into prior to 20 May 2010 are eligible for relief under Notice 97-66, and the U.S. Internal Revenue Service (IRS) may challenge them under existing law, "including by applying judicial doctrines, as appropriate."[13]
Caveat – The IRS likely will presume a principal purpose of reducing tax if the net cash flow from a substitute dividend payment is greater than what would flow to the lender had it received an actual dividend net of the applicable U.S. gross-basis tax.
2. Access to future §871(l)(6) relief. A foreign financial institution that structures or engages in a stock loan or repo, or series of such transactions, after 19 May 2010 that the IRS determines had a principal purpose of reducing or eliminating the aggregate amount of U.S. tax that would have been due in the absence of such transaction or series of transactions will be disqualified for five years from eligibility to be treated as a QSL under the new rules effective for payments made after 13 September 2010.
Recommendation – As discussed more fully below, the benefits of QSL status are substantial. Therefore, taxpayers that plan to engage in a stock lending business with customers are well-advised to avoid a five-year ban on QSL status.
To achieve this goal, parties to stock loans or repos would do well to exercise care, in cases in which the foreign payor and foreign payee of a substitute dividend payment face the same gross-basis tax rate on U.S. source dividend payments, before concluding that the formulary method of Notice 97-66 excuses the parties from paying (or collecting by withholding) U.S. gross-basis tax. As noted above, if a lender is provided a cash flow yield from the substitute payment that exceeds the net dividend (i.e. the gross dividend amount, less U.S. gross-basis tax) that would have been received had the stock been held and not been loaned out over the dividend record date, the IRS may be likely to view the loan as grounds for imposing the five-year ban on QSL status - notwithstanding that the formulary method of Notice 97-66 may exempt the substitute payment from withholding through 13 September 2010.
3. Over-withholding relief not extended to "dividend equivalents" under "specified notional principal contracts." For dividend-based payments under notional principal contracts, §871(l) overrules, in stages, the residence-based sourcing rule of Reg. §1.863-7. It does this by treating as U.S. source income any payment that is pursuant to a "specified" notional principal contract, and that is contingent upon or determined by reference to the payment of a U.S. source dividend.[14] (Such payments are included in the definition of "dividend equivalents" in §871(l)(2).) However, Notice 2010-46 does not provide over-withholding relief to these dividend equivalents. Thus, cascading withholding could result from a series of stock loans and repos if a specified notional principal contract is part of the series, even if the series would have been free of over-withholding (under the principles of the notice) had there been no specified notional principal contract included.
II. The coming "Qualified Securities Lender" (QSL) regime
For the second and third periods covered by the notice, over-withholding relief from cascading gross-basis tax is provided in two ways: first, through the benefits afforded to foreign financial institutions that achieve QSL status; second, if QSL status does not apply, through a "credit forward" regime applicable to withholding agents. The credit forward regime grants a withholding agent the right to reduce withholding on substitute payments it makes to a foreign non-QSL by the amount of withholding that is treated as previously imposed in the same series of transfers of the same shares of stock.
Effect of QSL status
The regulations contemplated for period 3 will provide that:
- A borrower making a substitute dividend payment beneficially owned by a foreign financial institution need not withhold U.S. gross-basis tax on the payment if the institution certifies that it is a QSL; and
- The QSL will not be liable for gross-basis tax on its substitute dividend receipts to the extent that they are offset by substitute dividend payments that the QSL makes with respect to identical securities.
We believe that Treasury intends substitute payments to U.S. payees (as well as to foreign payees) to be usable to offset a QSL's own gross-basis tax liability. Where there is no offsetting payment, and the QSL is liable for gross-basis tax on a substitute dividend payment it receives, it is only the QSL, and not the withholding agent, that must file a return and pay the tax.
The rules applicable in period 2 will include rules similar to the foregoing, except that, in the absence of regulatory guidance, it is up to withholding agents, if they wish to avail themselves of the QSL regime, to "adopt a system that reasonably implements the principles of the [QSL] system described in Part II of this notice" - that is, the part of the notice outlining the regulations that will take effect in period 3.
What will it take to be a QSL?
QSL status will generally be available to any foreign financial institution (bank, custodian, broker-dealer or clearing organization under regulatory supervision by its country of incorporation) that is regularly engaged in a trade or business that includes borrowing securities of U.S. corporations from, and lending such securities to, unrelated customers, so long as the institution is either subject to IRS audit (under §7602), or is a Qualified Intermediary (QI) subject to external audit and that agrees to be subject to the QSL rules (which will ultimately entail an amendment of its existing QI agreement). [15]
Anti-abuse rules
Withholding agents may not rely on the transition relief for period 2 with respect to a Securities Lending Transaction, or series of such transactions, that is entered into with a principal purpose of reducing or eliminating the aggregate amount of U.S. tax that would have been due in the absence of such transaction or series of transactions. This rule applies to eligibility for the QSL regime and for the credit forward benefits afforded against withholding on payments to non-QSLs discussed below. A financial institution that is determined by the IRS to have structured or engaged in one or more transactions described in the preceding sentence on or after 20 May 2010 will not qualify as a QSL for a period of five years from the date of such determination.
In addition, the regulations will provide that a withholding agent or a QSL may not rely on any of the over-withholding relief rules (including any certifications of QSL status provided by a lender) when the withholding agent or QSL knows or has reason to know that a Securities Lending Transaction, or series of such transactions, has a principal purpose of reducing or eliminating the amount of U.S. gross-basis tax that would have been due in the absence of such transaction or transactions. In such a case, a withholding agent or QSL must withhold, and the recipient of such payment is subject to U.S. gross-basis tax, at the 30% rate (subject to reduction under an applicable income tax treaty) on each substitute dividend payment with respect to such transaction.
Observations on new QSL regime
Significant QSL advantage. QSL status is likely to be crucial, as a practical matter, to a foreign institution's ability to engage in a stock lending business outside the United States as a principal (rather than only as an agent for customers for whom it holds shares in custody). The absence of a requirement to withhold on payments to a lender that is a QSL, for example, may enable the QSL as an economic matter to "fund" its loan by borrowing from a U.S. person, from whom borrowers can typically only borrow if they obligate themselves to make substitute dividend payments free of reduction by the amount of any withholding tax.[16]
In addition, a QSL's novel ability, for U.S. gross-basis tax purposes, to net (outgoing) substitute dividends paid against (incoming) substitute dividends received effectively converts the gross-basis tax into a net-basis tax to some extent. This unique privilege puts a foreign institution that achieves QSL status on a par with a U.S. institution, in terms of its ability to function in its home country as an intermediary in the market between traders who need to borrow stock (e.g. to cover their short sales) and investors who are willing to lend U.S. stock.[17] In contrast, foreign non-QSLs acting as principal will be subject to the gross-basis tax on substitute dividends received, regardless of whether the foreign principal owes a corresponding substitute payment to a U.S. or foreign lender.
Identification of securities used in borrowings and lendings. To determine during the transition period those of its substitute dividend receipts for which it owes the United States no gross-basis tax (due to the offset described above), a QSL may use any reasonable method, consistently applied, to identify which securities in a fungible pool have actually been borrowed and lent. Notice 2010-46 does not discuss application of Reg. §1.6045-2 ("Furnishing statement required with respect to certain substitute payments") to the new QSL regime. Pending further guidance, it would seem sensible for the IRS and Treasury to view application of Reg. §1.6045-2(f)(2) principles for determining the offsetting payments received and paid by a QSL [18] as a reasonable way to implement the notice's requirements.
III. The alternative "credit forward" regime for payments to non-QSLs
For payments made to non-QSLs, §871(l)(6) over-withholding relief is provided to withholding agents in periods 2 and 3 through what is called a "credit forward" approach. This approach is permitted for substitute dividend payments and dividends made in an identified series of Securities Lending Transactions.
The regulations are expected to provide that withholding agents may relieve excessive withholding on substitute dividends made in a series of loans by an amount not to exceed the amount that has been previously withheld within the same series of Securities Lending Transactions, but only to the extent that there is sufficient evidence that tax was actually withheld on a prior dividend and/or substitute dividend paid to the withholding agent or a prior withholding agent within the same series.
The purpose of this rule is to limit the aggregate gross-basis tax within a series of Securities Lending Transactions to the highest rate of gross basis tax that would apply to any foreign taxpayer on a substitute or actual dividend received with respect to the underlying stock transferred in the series. The aggregate tax thus is expected not to exceed 30%. As discussed below, the applicable rule for period 2 is similar.
Observation – Although the aggregate tax is intended to be limited to 30%, it is not entirely clear whether that goal will be achieved when one or more lenders in a series of transactions does not provide Forms W-8BEN ("Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding") or W-9 ("Request for Taxpayer Identification Number and Certificate"), or whether some over-withholding will result in a series in which one of the lenders does not comply with reporting or other compliance rules.
Withholding relief is allowed only for prior withholding in the same series of transactions. No refund is allowed for a higher rate of tax imposed in the series, for instance where a U.K. lender receives a substitute dividend payment from a resident of a non-treaty country who bore a 30% U.S. gross-basis tax on the actual dividend or a substitute dividend payment. No tax withheld in one series of transactions may be used to offset withholding tax due in another series of transactions.
What constitutes sufficient evidence of prior withholding?
Period 3: The regulations. The regulations are expected to provide that a withholding agent may presume that tax has been withheld by a prior withholding agent in a series of transactions if all of the following conditions are satisfied:
- The withholding agent receives a substitute dividend net of U.S. withholding taxes;
- The withholding agent receives a written statement from the immediately prior withholding agent providing the amount of such taxes;
- The withholding agent identifies the person who withheld the tax and the recipient of prior payment against which the tax was withheld; and
- The withholding agent does not know or have reason to know that the statement is unreliable.
The notice states that the withholding agent may not rely on evidence of the sale of the underlying security to determine whether tax has been paid or withheld. While this statement is unexplained, a sale before the dividend is paid would break the chain of information leading back from the last recipient of a substitute dividend payment to the first payor of such a payment in the series. (Put another way, such a sale would break the chain of information leading back to the first lender of the shares from the last borrower of the shares before the dividend date.)[19] The rule would prohibit a withholding agent from making a presumption about U.S. tax information that is no longer being passed down the chain.
Period 2: Before the regulations. The notice states that a withholding agent that is obligated to make a substitute dividend payment pursuant to a Securities Lending Transaction in the transition period may presume that U.S. tax has been paid in an amount equal to the amount "implied by the net payment" if all of the following are satisfied:
- The withholding agent receives a substitute dividend or dividend payment with respect to identical securities that reflects a reduction for withholding of U.S. gross-basis tax;
- The withholding agent does not know or have reason to know that tax was not withheld and deposited or paid; and
- The withholding agent is a person subject to audit under §7602, or in the case of a QI, by an external auditor.
A withholding agent is treated as having reason to know that tax was not withheld if, for example, the amount of any lending fee or similar fee is increased directly or indirectly, in whole or in part, by the difference between the gross amount of the substitute dividend and the net amount received.
IV. Conclusion
Notice 2010-46 provides the first guidance issued under the HIRE Act, and the end of a 12-year waiting period to see how Treasury would integrate its temporary fix (Notice 97-66) to the securities lending regulations with the comprehensive revision to the withholding regime that took effect in 2001.
The most notable aspect of Notice 2010-46 is the QSL regime, which extends some, but not all, of the exemption benefits provided to foreign securities lenders under Notice 97-66, but under criteria based on the lender's customer-based activities (rather than on residency in a jurisdiction bearing the same rate of gross basis tax as the borrower's jurisdiction). The QSL regime provides, for the first time, the benefits of QI inclusion and QI-like treatment (for eligible non-QIs) for financial institutions' proprietary stock lending transactions. Obtaining and maintaining QSL status is likely to be a competitive necessity for dealers in the stock lending markets. No doubt the drafters of the notice hope that this, in turn, will put a premium on a firm's ability to avoid becoming subject to the five-year ban that the drafters designed as a strong incentive for strict compliance, and a penalty for structuring or engaging in what they (or Congressional critics of "dividend tax abuse") view as tax avoidance transactions.
Endnotes
1 The term "gross-basis tax" is generally used in this Alert to refer to the U.S. tax, if any, that is imposed on an item of gross income of a nonresident alien individual, a foreign corporation, or a foreign organization that is a private foundation, by §§871(a), 881, 1441-1464, 1471-1474, or 4948(a) of the U.S. Internal Revenue Code (the "Code").
2 "Substitute dividend payments" are payments in securities lending transactions (§1058 or substantially similar transactions) where the securities are shares of stock ("stock loans" or "loans"), and stock share sale-repurchase transactions ("stock repos" or "repos"). The notice refers to loans and repos collectively as "Securities Lending Transactions.
3 Broker/dealers in stock often need to borrow U.S. stock in order to carry on the business of being a broker/dealer. Firms (or individuals) that are traders in stock often need to borrow U.S. stock in order to achieve the (non-tax) goals at which their trading strategies are aimed (e.g. profiting from the future deterioration in market value of a particular company or issuance through short selling). In light of this demand for stock loans, individuals, funds, or firms (including foreign ones) that hold U.S. stock as part of their investment portfolios (or trading strategies) will often lend the stock that they own to dealers or traders seeking to borrow. Financial institutions (including foreign firms) may borrow stock and on-lend it as part of their financial services businesses.
4 2010-24 I.R.B. 757.
5 Foreign-to-foreign substitute dividends payments are generally U.S. source income of the recipient if determined by reference to U.S. source dividends. See Reg. §1.861-3(a)(6), fourth sentence.
6 Code §871(l) was added by §541 of the Hiring Incentives to Restore Employment Act ("HIRE Act"), Pub. L. No. 111-147, 124 Stat. 71 (18 March 2010).
7 "Over-withholding" could be said to occur if the aggregate of the U.S. gross-basis taxes imposed on all recipients of dividends and substitute dividend payments in a series of stock loans and repos, and on all withholding agents in the series, exceeds 30% (or 15%, in a case where all non-U.S. beneficial owners of payments in the series are residents of treaty countries entitled to a limit of 15% on the U.S. tax on dividends).
8 §871(l)(6) applies in the case of any chain of "dividend equivalents" as defined in new §871(l)(2) ("dividend equivalents" include both substitute dividend payments and certain payments on stock-based notional principal contracts) and/or actual dividends, one or more of which is subject to U.S. gross-basis taxation.
9 1997-2 C.B. 328.
10 These rules apply to payments between 14 September 2010 and 31 December 2011 with respect to transactions entered into any time before or after the notice was issued.
11 Under this method, "the amount of U.S. withholding tax to be imposed under section 1.871-7(b)(2) and 1.881-2(b)(2) with respect to a foreign-to-foreign payment will be the amount of the underlying dividend multiplied by a rate equal to the excess of the rate of U.S. withholding tax that would be applicable to U.S. source dividends paid by a U.S. person directly to the recipient of the substitute payment over the rate of U.S. withholding tax that would be applicable to U.S. source dividends paid by a U.S. person directly to the payor of the substitute payment." Therefore, "no withholding tax is required in situations where transactions are entered into between residents of the same country," or between residents of different countries who both face the same rate of U.S. gross-basis tax on U.S. source dividends. Notice 2010-46 cites a staff report of the Senate Permanent Subcommittee on Investigations for claims that "some taxpayers have relied on Notice 97-66 to avoid U.S. gross-basis taxation of foreign lenders of U.S. dividend-paying stocks in transactions undertaken primarily to enhance the after-tax yield of U.S. dividend-paying stocks held by foreign persons." See Staff of the Permanent Subcomm. on Investigations, Senate Comm. on Homeland Security and Governmental Affairs, "Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends," reprinted in S. Hrg. 110-778, the transcript of the hearing on this topic held 11 September 2008.
12 See Reg. §§1.871-7(b)(2), 1.881-2(b)(2) and 1.894-1(c).
13 The treatment under existing rules of swap payments on notional principal contracts entered into incident to a stock purchase is currently a matter in controversy in the U.S. Tax Court in Arbitex Master Fund, L.P. v. Commissione, Docket No. 6239-10 (petition filed 12 March 2010). While Arbitex concerns a notional principal contract in form, it is unclear whether the IRS is seeking to treat the arrangement between Arbitex and its counterparty as a transaction that is "substantially similar," under Reg. §1.861-3(a)(6) (in the context of defining a "securities lending transaction"), to a loan or repo.
14 For purposes of §871(l), in the case of payments made after 18 March 2012, the term "specified notional principal contract" means any notional principal contract, unless the Secretary determines that such contract is of a type that does not have the potential for tax avoidance. §871(l)(3)(B). In the case of payments made between 14 September 2010 and 17 March 2012, §871(l)(3)(A) provides that the term means a notional principal contract that has any one or more of the following five characteristics:
1. in connection with entering into such contract, any long party to the contract transfers the underlying security to any short party to the contract,
2. in connection with the termination of such contract, any short party to the contract transfers the underlying security to any long party to the contract,
3. the underlying security is not readily tradable on an established securities market,
4. in connection with entering into such contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract, or
5. such contract is identified by the Treasury Secretary as a specified notional principal contract.
15 Substitute payments received and made in custody are already included in the current QI regime under existing QI agreements.
16 Notice 2010-46 provides that a QSL must undertake reporting and backup withholding responsibilities under chapter 61 ("Information and Returns") and §3406 ("Backup Withholding") for substitute payments it makes either as principal or in custody to U.S. persons. Evidently, the notice's drafters intended that QSLs be permitted to reduce gross-basis tax on substitute dividend receipts by their substitute dividend payments to U.S. (as well as foreign) persons.
17 Stock lending operations of the foreign institution which generate only income effectively connected with the conduct of a U.S. trade or business ("effectively connected income" or "ECI") generally might already have been on a level tax playing field with those of U.S. institutions; but home country operations of foreign institutions, or other operations generating non-ECI, are ones particularly benefitted in this respect by the availability of the QSL regime.
18 Reg. §1.6045-2(f)(2) provides a method for brokers to allocate shares giving rise to substitute dividend receipts amongst all the "loanable shares" borrowed by the broker or held by the broker for customers.
19 That is, if A lends shares to B and B makes a substitute dividend payment to A, A knows its tax status and what B withheld on the payment it made to A. But there are two mutually exclusive possibilities regarding B's knowledge of withholding down the chain. If B lent the shares to C, and C made a substitute dividend payment to B, B knows its own tax status and what C withheld on the payment it made to B, and B can report this information back to A. But if B sold the shares to C before the dividend payment, B may have reaped the economic benefit of selling the shares cum dividend (which roughly compensates B for the substitute payment it makes to A), but B will receive no documentation from C regarding the U.S. gross-basis tax, if any, imposed on that dividend. Thus, there may be no documentary chain available for use by A (or its auditors) to reconstruct the tax that was imposed on parties "down the chain" past B.
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